What happens when Ottawa runs out of surpluses?

It should be clear to all political parties by now that, after 2015, there will be little in the way of fiscal surpluses for the federal government to use for critical policy challenges. The modest surpluses currently projected to begin in 2015-16 will be rapidly used up and forecast economic growth will not be enough to generate sizeable annual surpluses for the foreseeable future. The surplus budgets of the 1990s and 2000 to 2007-08 will not be repeated.

Budget 2014 forecast surpluses of $6.4 billion in 2015-16, $8.1 billion in both 2016-17 and 2017-18 and $10.3 billion in 2018-19. The Finance Department is projecting surpluses of around $10 billion until 2025-26.

That sounds like a lot, but remember — the federal government has committed much of it already: $3 billion per year for debt reduction, another $3 billion annually for the 2011 election commitments, including income-splitting ($2.7 billion), doubling the children’s fitness tax credit ($100 million) and introducing a new adult fitness tax credit ($500 million).

Ottawa also has re-profiled over $6.5 billion of defense spending to some point in the future, yet to be announced. These commitments, if fulfilled, would exhaust the entire surplus in 2015-16 and leave little room for other initiatives over the next five years and beyond.

The government elected in 2015 will have to confront the question of whether, and how, to raise new money. So what are the options? Whatever fiscal strategy the federal government chooses after 2015, maintaining fiscal sustainability will be absolutely critical.

‘Fiscal sustainability’, as defined by the Organization for Economic Co-operation and Development and the International Monetary Fund, is a climate in which a government has a “low” and “stable”, or declining, debt burden (that’s the ratio of debt to GDP). So what’s a “low” debt burden? Why is a debt burden of 25 per cent (the federal government’s current target) better than a target of 30 per cent, or 40 per cent, or even 60 per cent, the current target for eurozone countries?

One possible fiscal strategy for a new government would be to do nothing (or next to nothing) to address the serious policy challenges on the horizon: our aging population, crumbling infrastructure, fractured health care system, the deterioration of conditions in aboriginal communities, threats to the environment, the erosion of the manufacturing sector, the inadequate education and training of young Canadians — to name just a few.

A ‘do nothing’ fiscal strategy would, in some respects, represent a continuation of the ideological approach of the current Conservative government. It would reflect the view that most of these policy challenges fall under provincial jurisdiction anyway and that the best way for the federal government to contribute would be to continue shrinking. This view implies that provincial governments would have to absorb the tax ‘room’ vacated by the federal government.

The fiscal projections in Budget 2014 provide a reasonable approximation of what might happen under such a fiscal strategy. Program spending, as a share of GDP, is forecast to decline from 13.5 per cent in 2013-14 to 12.4 per cent in 2018-19. In other words, the federal government is expected to continue to decline in size and influence. With the Harper’s government use of tax expenditures, revenues as a share of GDP are forecast to remain relatively stable at about 14.5 per cent.

More importantly, the debt burden of the federal government is forecast to fall from 33.0 per cent in 2013-14 to 25.5 per cent in 2018-19. It is expected to continue falling to 25 per cent — the government’s target — in 2021-22, if not earlier. It’s not clear what the federal government would do at that point. To date, Ottawa has been silent on this question.

In the absence of any change in spending and taxation policies, the federal debt burden would continue to fall until the government eventually became a net creditor.

Of course, there is no theoretical, practical, or empirical reason to support such a fiscal strategy. So what would a new government have to do to stabilize the debt burden, at whatever target it chose?

The problem is that the policy challenges facing this country are simply too important to be ignored — or to be continually downloaded onto the provinces and the private sector. Inevitably, the federal government would have to consider alternative fiscal strategies that would create financial resources.

In order to stabilize the debt-to-GDP ratio — at 25 per cent, for example — debt must begin to grow at the same rate as nominal GDP. In other words, the government would not only have to start running deficits, it would have to incur ever-increasing deficits.

This would present Conservatives, who are ideologically opposed to all deficits, with a policy conundrum. How could the Conservative party adopt a fiscal strategy of increasing deficits and growing debt in order to stabilize the debt burden at 25 per cent?

It couldn’t — the Conservative base would never accept it. In last October’s throne speech, the government rejected such a fiscal strategy by committing to balanced-budget legislation and to a further reduction in the role and size of the federal government.

The problem, however, is that the policy challenges facing this country are simply too important to be ignored — or to be continually downloaded onto the provinces and the private sector. Inevitably, the federal government would have to consider alternative fiscal strategies that would create financial resources.

One possible fiscal strategy for a future non-Conservative government would be to simply raise taxes — ideally, the GST. We know this is not going to be part of any 2015 election platform. Both the Conservatives and the Liberals have taken a political oath against raising any taxes, at least before the election. The NDP have said they would only raise corporate taxes — one of the worst taxes to increase.

Notwithstanding all the promises before the election that taxes will not be raised, any new government will eventually have to consider this option. The federal government will need more money to address the challenges that lie ahead. It won’t be able to ignore them forever.

Simply by restoring the two points of GST cut by the Conservative government, the government would create a $15 billion annual revenue stream that it could expect to see grow. This could be used to fund a significant reduction in income taxes for all low- and middle-income Canadians, along with paying for other policy improvements. Furthermore, shifting taxation away from income and towards consumption would yield significant benefits for economic growth and job creation.

The federal government also could free up a lot of revenue by undertaking a much-needed simplification of the personal and corporate income tax systems. The House of Commons Standing Committee on Finance has called for this in each of its last three pre-budget reports.

The 1917 Income Tax Act was 11 pages long. Today, it runs to 2,800 pages, having grown not only in size but in complexity. Governments have been using the tax system to carry out economic and social policies through tax expenditures, avoiding the scrutiny that that such programs would face if they were part of direct spending. Ottawa needs to review the hundreds of targeted tax measures and throw out the ones we don’t need, or aren’t relevant.

Studies have shown that tax simplification could generate savings of up to $5 billion annually, which would increase total available funding to $20 billion annually. All that’s required is the political will.

Another fiscal strategy a new government might consider is debt financing — in other words, going back into deficit to address immediate policy challenges. Many so-called ‘experts’ in the media regard this as worse than raising taxes. To them — and possibly to most Canadians — a government should never run a deficit outside of an economic downturn.

However, there are other situations where deficits might be justified. Most people would agree that certain types of government investments are typically used for generations — highways, transit systems, educational institutions, scientific research, to name a few. If future generations are going to benefit from these investments, then it’s reasonable to expect them to help pay for them through debt.

Debt financing may sound too good to be true; it may very well be. The Liberals didn’t stick to the rules in the 1970s, nor did the Conservatives in the 1980s; the result was a rising debt burden and eventually a financial crisis.

Even better, we could design a debt financing strategy that would be consistent with a sustainable fiscal structure. A stable debt-to-GDP ratio — for example, the government’s current target of 25 per cent — only requires that debt grow at the same rate as the economy. Assume nominal GDP growth at 4 per cent annually and debt also would have to grow at no more than 4 per cent.

Debt financing may sound too good to be true; it may very well be. Debt financing would present major challenges to any government. To succeed, the government would always have to balance the operating budget — that part of the budget that includes all spending other than capital or investment expenditures. That would not be easy. There is nothing to guarantee that any future government would stick to these conditions. The Liberals didn’t stick to them in the 1970s, nor did the Conservatives in the 1980s; the result was a rising debt burden and eventually a financial crisis.

In Alberta, a Conservative government has adopted debt financing for major capital initiatives. The budget is separated into three major components: Operational Plan, consisting of operating expenses; Capital Plan, for the financing of long-term provincial and municipal capital assets; and Savings Plan, which sets aside a portion of non-renewal resource revenues each year. The Operational Plan cannot run a deficit. Debt financing can only be incurred for the Capital Plan.

These fiscal strategies would, no doubt, be met with some skepticism by Canadians. No surprise there. Canadians have been told over and over that all deficits and debt are ‘bad’ and that, once the deficit has been eliminated, everything will be just fine. “Just be patient,” we’re told. “There will be plenty of money and the government will give some of you (i.e., the 15 per cent of families who would benefit from income-splitting) another ‘tax cut’.”

The reality is that there is not going to be plenty of money and things are not going to be ‘just fine’.

The next decade will present most Canadians with choices they have not had to make before. In the 1970s, 1980s and early 1990s, the debt burden was rising and the fiscal structure was not sustainable. In the late 1990s and the period up to 2007-08, we had year after year of surpluses, thanks to strong global and domestic economic growth. This permitted important new spending on education, research, infrastructure, health care, aboriginals and equalization. These surpluses also allowed the largest personal and corporate income tax cut in history. All of this was done while maintaining a sustainable fiscal structure. This period of surpluses came to an end with the two-point reductions in the GST in 2006 and 2007.

With the restraint actions taken since 2010 (made primarily to offset the reduction in revenues from the GST cuts) and the prospective elimination of the deficit, the government has once again achieved a sustainable fiscal structure. But there will be no ‘surplus financing’ available in the coming decade to meet the key policy challenges that will lie ahead.

New approaches will need to be considered, including debt financing and root-and-branch tax reform. Both can be done while maintaining a low and stable debt burden. Both can contribute to stronger economic growth. Both could be combined into a single fiscal strategy to deal with the inevitable policy challenges.

The real policy debate Canadians and political parties should be having in the lead-up to the 2015 election is about the role and size of the government and their implications for fiscal policy. Unfortunately, this debate probably won’t happen soon — maybe not even in the 2015 election.

But it will happen. Sooner would be better than later.

Scott Clark is president of C.S. Clark Consulting. Together with Peter DeVries he writes the public policy blog 3DPolicy. Prior to that he held a number of senior positions in the Canadian government dealing with both domestic and international policy issues, including deputy minister of finance and senior adviser to the prime minister. He has an honours BA in economics and mathematics from Queen’s University and a PhD in economics from the University of California at Berkeley.

Peter DeVries is a consultant in fiscal policy and public management issues, primarily on an international basis. From 1984 to 2005, he held a number of senior positions in the Department of Finance, including director of the Fiscal Policy Division, responsible for overall preparation of the federal budget. Mr. DeVries holds an MA in economics from McMaster University.

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